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Commentary By Steven Malanga

Why Inflation Is So Scary

German Chancellor Angela Merkel’s rebuke last week of central bank policies, including the loose money strategy of the U.S. Federal Reserve, didn’t get very much play in the American media, perhaps because to editors and producers it was just another moment in the theoretical debate over whether we should be worrying more about inflation or deflation and unemployment.

People took more notice in Europe, however, where media outlets used words like “astonishing” to characterize her speech. There, perhaps, they understand more clearly that Germany, scarred by the hyperinflation of the Weimar years which helped lead to chaos and then Hitler’s political ascent, has charted a far more conservative, tight-fisted post-World War II fiscal policy than most developed nations. Merkel’s speech was an indication of just how much German leaders are worried that central banks might be laying the groundwork for a new worldwide inflation with their stimulus spending, big deficits and printing of money.

To the Germans this is not merely a theoretical discussion, and maybe it shouldn’t be to us, either. Although few people in Germany actually “remember” the Weimar years because not many were alive then, the lessons of that era (and perhaps the notion of the pain the country experienced) have been repeated over and over again until they have been seared into Germany’s national consciousness.

By contrast, we’ve largely forgotten our most recent brush with raging peacetime inflation, the 1970s. Although nothing like Germany’s in the 1920s, ours was nonetheless powerful enough to be more dispiriting and more transformative of our culture than any stretch of post-World War II recession has been. It’s probably not a coincidence that America began its long transformation from a nation of savers to one of consumers and debtors just after the inflation of the 1970s. That’s what can happen when money seems to be “crumbling to dust in your hands,” as Fortune magazine described the inflation of that era.

One reason that inflation can be such a powerful social force is because it affects virtually everyone. To people who’ve worked their whole lives playing by the rules, that is, to the majority of adult Americans in the early 1970s, inflation at the hands of wayward government policy seemed to be a betrayal. People who had been thriftiest watched down payments for buying a home disappear, college savings accounts shrivel, retirement nest eggs vanish, the value of monthly pension checks shrink. Harvard Business School Professor Samuel Hayes recounted the damage to a relative of his in a magazine story: “He was the epitome of the Protestant ethic. He had inherited money, he had saved, he was very frugal, had a very modest house, had part of his investment money in bonds and short-term securities, had always maintained liquidity. And he came out of the Seventies looking like a fool.”

In the 1970s, inflation turned the chronology of the American dream on its head and made our lives less predictable and more chaotic. What I remember was how our own family’s financial situation became tenser and more anxious than it had been just a half-decade earlier even though my father’s career and salary had advanced over time. This was what inflation did, taking people who thought they were building economic security and upending it.

The anxiety and confusion was not terribly surprising given that through the 1950s and 1960s Americans got comfortable with prices that rose just 21 percent and 24 percent, respectively, per decade, but then increased by 150 percent between 1970 and 1982 before Fed chairman Paul Volcker, backed by President Reagan, applied the tough medicine that broke inflation.

Still, after a 14 year roller-coaster of inflation, counting the upward surge that began in 1968, America was a different country by 1982. Subsequently, our savings rate declined and our consumer debt started rising more rapidly. Our fascination with real estate mounted, as those who had bought homes in the 1970s saw their value soar and their mortgage payments decline relative to their incomes—windfalls that transformed the way people looked at housing ownership and the amount of money they might borrow to buy a home. “Buy, buy, buy, buy” was the message of the inflationary 1970s to the average America, Fortune opined.

A new round of inflation would send some of the very same messages as in the 1970s. It would undercut those who behaved most sensibly during the recent housing bubble—who took out affordable mortgages and banked money toward their retirement-- by eroding the value of what they saved. It would significantly raise people’s anxiety about the future. How much money will we need to retire on? To buy that house that is our dream? In inflationary times, the goal line for such things keeps moving further and further away, as if someone is painting and repainting the lines on the field every day. You think the stock market has wrecked havoc on your 401(k)? Just hope you don’t get to see what inflation does to it.

In such an environment the only thing that is predicable is that calls for government to provide a greater safety net—as in increasing cost-of-living adjustments for Social Security benefits—grow stronger.

Of course central bankers, including our own Ben Bernanke, reacted to Merkel’s warning by assuring us they are ready to react to the first signs of inflation, but meanwhile have to continue battling to end the recession. Yet in their responses they create the illusion that stopping inflation is as simple as flicking a switch off (presumably on printing presses.) In fact, having put lots of money into the financial system, the Fed will have to soak it back up using a variety of methods that aren’t foolproof and may not work as advertised given the unprecedented nature of the financial interventions by central banks and governments around the world in recent months. The current financial crisis has already tested some of our basic assumptions about how markets work, yet central bankers remain confident their traditional tools for taming inflation will work.

The risk is especially high given that the academic research on stimulus and loose money suggests that the payback for our current approach in terms of net jobs created or, more controversially, “saved,” is not very great. There are probably more limited, less risky ways we could have dealt with rising unemployment—such as extending benefits for longer periods to the jobless—than juicing up our entire financial system in an effort to shorten the recession.

We’ve gone that route, I fear, because we’ve forgotten that inflation is a game-changer, a culture-changer. Let’s hope we don’t relearn that lesson the hard way.

This piece originally appeared in RealClearMarkets

This piece originally appeared in RealClearMarkets